Why Has the Financial Sector Grown so Much? The Role of Corporate Finance.

Thomas Philippon New York University, NBER and CEPR

July 2008
1

Equilibrium Size of Financial Sector

Economic Share of Finance Industry

.08 8 0 .02 ncome Sh hare In .04 .06

1860

1880

1900

1920 1940 year

1960

1980

2000

Within nance
Subsectors Shares of GDP (g 2) Value added vs. assets under management (g 3)

Equilibrium Size of Financial Sector

Figure 2: GDP Shares of Finance Industries

Credit Inter. 0.045 0.04 0.035 0.03 0.025 0.02 0.015 0.01 0.005 0

Insur.

Trusts & Funds

Priv. Eq & Inv Bk

19 97

19 99

19 95

20 01

19 91

19 93

20 03

Source: U.S. Annual Industry Accounts, Bureau of Economic Analysis

19 77

19 79

19 81

19 83

19 85

19 87

19 89

20 05

Within nance
Subsectors Shares of GDP (g 2) Value added vs. assets under management (g 3) Functional analysis: A trader is a trader tasks performed vs. industry classication (g4)

Equilibrium Size of Financial Sector

Finance Activity related to Corporate Finance.

0.9 0.8 0.7 0.6 0.5 05 0.4 0.3 0.2 02 0.1 0

BASELINE BASE-ADMIN

Within nance
Subsectors Shares of GDP (g 2) Value added vs. assets under management (g 3) Functional analysis: A trader is a trader tasks performed vs. industry classication (g4) Bottom line: importance of corporate nance and credit intermediation

Equilibrium Size of Financial Sector

Potential explanations
Globalization Financial globalization starts later Not highly correlated over long period U.S. nancial sector is not a large exporter (unlike UK) Finance is special ...empirically Dierent from rest of service industry (see health care in Table 1) Finance is special...theoretically Elasticity of substitution not applicable Growth. Neither in theory nor in practice

Equilibrium Size of Financial Sector

Taking stock
Importance of Finance in the economy varies a lot Why? Types of growth? Look for an explanation inside the domestic corporate non nancial sector Fundamental determinants of nance share of income? Need a model to organize the data Explicit role for nancial intetmediation Career choice & general equilibrium

Equilibrium Size of Financial Sector

Technology and Preferences

Overlapping generations of risk neutral agents

i i = E C i + Ct+1 Ut t t

1+

Agent chooses a career in the rst period of her life Each cohort of size 1 Two sectors Industrial sector: nt Financial sector: 1 nt

Equilibrium Size of Financial Sector

existing capital: kt

nt generation born at t 1-nt

existing capital: kt current output: F(nt, kt) indiv. i di prod. i d

nt generation born at t 1-nt

existing capital: kt current output: F(nt, kt) indiv. i di prod. i d fraction gets idea nt generation born at t 1-nt
rich enough

new capital kt+1 1

new projects productivity

existing capital: kt current output: F(nt, kt) indiv. i di prod. i d fraction gets idea nt generation born at t 1-nt
rich enough too poor
Simple MH and monitoring

new capital kt+1 1

new projects productivity

financial sector productivity

Savings
existing capital: kt current output: F(nt, kt) indiv. i di prod. i d fraction gets idea nt generation born at t 1-nt
rich enough too poor

new capital kt+1 1

new projects productivity

financial sector productivity

existing capital: kt

Demand for fin. services

new capital kt+1 1

current output: F(nt, kt) indiv. i di prod. i d fraction gets idea nt generation born at t
rich enough too poor

new projects productivity

joint di t j i t dist. innovative ideas & current income 1-nt financial sector productivity

existing capital: kt

Supply of fin. services

new capital kt+1 1

current output: F(nt, kt) indiv. i di prod. i d fraction gets idea nt generation born at t 1-nt
rich enough too poor

new projects productivity but et< nt

financial sector productivity

Equilibrium wihtout Financial Intermediation

Equilibrium Size of Financial Sector

Equilibrium without Moral Hazard

New projects Savings

Investment

Equilibrium with Moral Hazard

New projects Savings

Investment

Equilibrium Financial Intermediation

Career Choice = + 1 F (h) v + Monitoring Market Clearing (1 n) = n
Z h
l

(v m ()) dF ()

Z h
l

m () dF ()

Equilibrium Size of Financial Sector

Figure 9: Equilibrium With Monitoring

Density function f() Constrained 0 l Invest h 1

Monitored Finance

Direct Finance

Self Finance Self-Finance

Theoretical Comparative Statics

Proposition. The income share of the nancial sector is constant on the balanced growth path. For a given interest rate, the income share of nance is independent of the growth rate of the economy. The size of the nancial sector goes to zero when its eciency becomes either very small or very large. Eciency gains in nance reduce rationing and increase investment, but have an ambiguous eect on the GDP share of the nance industry.

10

Equilibrium Size of Financial Sector

Estimation of model parameters

Moments Investment share of low cash rms: F (0.33) F (l ) s= 1 F (l ) Investment share of GDP Corporate CMI over GDP Corporate nance share of GDP

11

Equilibrium Size of Financial Sector

Table 1: Data Investment Share of Firms with Income<0.33*Capex 28.51% 17.92% 14.61% 18.61% 20.41% 25.85% 35.37% 39.41% Non Financial Corporate Credit Market Instruments over GDP 58.79% 49.24% 30.24% 37.27% 47.34% 52.44% 60.41% 62.38%

Period

Finance Share of Compensation

Health Care Share of Compensation

1927-1931 1937-1941 1947-1955 1956-1965 1966-1975 1976-1985 1986-1995 1996-2005

5.03% 4.07% 2.99% 3.77% 4.12% 4.77% 5.87% 7.13%

0.87% 0.96% 1.21% 1.76% 3.11% 5.27% 7.89% 8.85%

Notes: Finance Share is the compensation of employees in the Finance and Insurance industry divided by the compensation of all employees. Investment share of low cash firms is the fraction of all capital expenditures in Compustat accounted for by firms whose income is less than one third of their capital expenditures. Before 1955, the investment share of low cash firms is estimated from turnover of industry leaders using CRSP. Before 1952, non financial corporate credit market is estimated using total corporate credit. Sources: National Income and Product Accounts, Annual Industry Accounts, CRSP, Compustat, Flow of Funds, and Historical Statistics of the United States.

Table 2: Estimation of Model Parameters Share of Compensation for Corporate Finance Services 2.26% Non Financial Corporate Credit Market Instruments over GDP 37.27%

Empirical Moments (1956-1965)

Investment Share of Firms with Income<0.33*Capex

Aggregate Investment over GDP

18.61%

11%

Severity of Micro Moral Efficiency of Corporate Hazard Finance

Technological Parameter

Distribution of Entrepreneur's Cash Flows

Implied Parameters

z/
0.74

/
4.22

E[]/
5.38

1.27

Notes: See Table 1 for a description of the data. Share of Compensation for Corporate Finance Services is 0.6 times the Share of Finance. The aggregate investment to GDP ratio is set at its post war average. Notice that 1-0.5 is the financing need for the median potential entrepreneur. Source: National Income and Product Accounts, Compustat, and Flow of Funds, NBER.

Testing model predictions

Calibrate to 1960. Keep (z, , , ) constant

12

Equilibrium Size of Financial Sector

Testing model predictions

Calibrate to 1960. Keep (z, , , ) constant Inputs Investment share of low cash rms Aggregate investment rate

13

Equilibrium Size of Financial Sector

Table 3: Testing the Model's Predictions

Fixed parameters Inputs Investment Aggregate Share of Investment Low Cash over GDP Firms 28.5% 17.9% 14.6% 18.6% 20.4% 25.8% 35.4% 39.4% 11.0% 10.0% 10.9% 11.0% 11.2% 11.1% 10.8% 11.2% Implied Time-Varying Parameters Predicted Values Realized Values Extra Prediction

z/
1927-1931 1937-1941 1947-1955 1956-1965 1966-1975 1976-1985 1986-1995 1996-2005 0.74 0.74 0.74 0.74 0.74 0.74 0.74 0.74

E[]/
5.38 5.38 5.38 5.38 5.38 5.38 5.38 5.38

/
4.52 3.18 3.87 4.22 4.60 4.59 4.42 4.90

Corporate Corporate Corporate Corporate Fraction of Finance Credit Finance Credit Credit Income Market over Income Market over Constrained Share GDP Share GDP Firms 3.29% 2.41% 1.87% 2.26% 2.41% 3.00% 4.01% 4.44% 53.6% 41.3% 31.3% 37.3% 39.3% 48.9% 61.0% 67.2% 3.52% 2.57% 1.48% 2.26% 2.61% 3.26% 4.36% 5.62% 58.8% 49.2% 30.2% 37.3% 47.3% 52.4% 60.4% 62.4% 9.0% 21.2% 10.3% 9.0% 6.5% 7.8% 11.6% 6.5%

0.94 0.94 1.41 1.27 1.29 1.04 0.77 0.76

Notes: See Table 1 and 2 for a complete description of the data. The moral hazard and technology parameters are estimated in 1956-1965 (see Table 2), and are kept constant over time. The two implied parameters (efficiency of financial intermediation and structural financing needs of entrepreneurs) are estimated by matching two time-varying inputs: investment over GDP and the investment share of low cash firms. The model is then used to predict the size of the credit market and the share of income devoted to corporate finance services. The actual values are from Table 1. The corporate finance income share is the finance income share minus a fixed fraction of 1.51% corresponding to other financial services.

Figure 6: Investment Shares of Low Cash Firms

0.6

0.5

s15

s25

s33

0.4

0.3

0.2

0.1

0
19 55 19 57 19 59 19 61 19 63 19 65 19 67 19 69 19 71 19 73 19 75 19 77 19 79 19 81 19 83 19 85 19 87 19 89 19 91 19 93 19 95 19 97 19 99 20 01 20 03 20 05

Notes: Sum of capital expenditures by firms whose income is less than 15%, 25% or 33% of their capital 15% expenditures, divided by the sum of capital expenditures by all the firms in the sample. Source: Authors calculations, Compustat sample of non financial firms.

Testing model predictions

Calibrate to 1960. Keep (z, , , ) constant Inputs Investment share of low cash rms Aggregate investment rate Implied parameters & historical interpretation

14

Equilibrium Size of Financial Sector

Figure 10: Implied Structural Parameters

Demand Index
0.65 0.60 0.55
1.00 1.20 1.10

Efficiency Index

0.50 0.45 0.40 0.35

0.70 0.90 0.80

0.30 0 30 0.25 0.20 19271931 19371941 19471955 19561965 19661975 19761985 19861995 19962005
0.60 0.50 19271931 19371941 19471955 19561965 19661975 19761985 19861995 19962005

Notes: The efficiency index is / normalized to one in 1956-1965. The demand index is the external finance needed for the median project, 1 /2. project 1-/2

Testing model predictions

Calibrate to 1960. Keep (z, , , ) constant Inputs Investment share of low cash rms Aggregate investment rate Implied parameters & historical interpretation Quantitative predictions: n. size and credit market

15

Equilibrium Size of Financial Sector

Figure 11: Predicted Size of Financial Sector

Income Share of Financial Sector (Corporate Finance Only)
0.060 0.050 0.040 0 040 0.030 0.020 0.010 0.000 19271927 1931 19371937 1941 19471947 1955 19561956 1965 19661966 1975 19761976 1985 19861986 1995 19961996 2005

Actual Predicted

Notes: Actual share is income share of finance and insurance minus the fraction that does not reflect corporate finance services (see Table 3). Predicted value constructed from estimated model using aggregate investment rate and s33 (investment share of low cash firms, and its predicted value before 1955) as inputs.

Figure 12: Predicted Size of Credit Market

Non Financial Corporate Credit Market Instruments / GDP
0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0 19271931 19371941 19471955 19561965 19661975 19761985 19861995 19962005 Actual Predicted

Notes: Corporate non financial credit market instruments from the Flow of Funds (1952-2006) over GDP. p ( ) Before 1952, predicted value using total corporate debt from Historical Statistics of the United States. Predicted value constructed from estimated model using aggregate investment rate and s33 (investment share of low cash firms, and its predicted value before 1955) as inputs.

Inputs
.12 1860 1880 1900 1920 1940 year y s33 1960 ik 1980 2000 . .02 .1 .04 4 .06 k ik .08 .2 s33 .3 3 .1 .4 4 .5

Demand Index
2 2.5 .5 D Demand In ndex 1 1.5 2

1860

1880

1900

1920 1940 year

1960

1980

2000

Model Predictions
.08 8 0 .02 .04 4 .06 6

1860

1880

1900

1920 1940 y year

1960

1980

2000

Income Share

Income Share - Predicted

.03 35

Railroads
.08 1860 1870 1880 1890 year 1900 1910 1920 Income Share Rail per Sq. Mile 0 .02 .04 4 .06 Rail per Sq. Mile

.01

.01 15

me Incom Share .02 .025

.03

Electricity
.0 06 4 45 1900 1910 1920 year Income Share 1930 Elect. Patents 1940 25 .02 30 35 Elect. Patents 40

Incom Share me .03 . .04 .0 05

I.T.
.08 -2 2 1960 1970 1980 year Income Share Log IT capital share 1990 2000 -6 -5 -4 -3 apital share e Log IT ca

.02

me Incom Share .04 .06

Table 4: Counter- Factual Experiments

/
Starting Values (from model) 4.22

1.27

Corporate Finance Income Share 2.26%

Fraction of Constrained Firms 9.04%

Final Values (from model)

4.90

0.76

4.44%

6.47%

Predicted by demand shift only

4.22

0.76

3.90%

13.91%

Predicted by efficiency gains only

4.90

1.27

2.60%

4.61%

Notes: Starting values correspond to 1956-1965. Final values correspond to 1996-2005. See Table 3. The model is non linear, so the effects are not additive.

Conclusion
Financial services in equilibrium Time varying needs A macro view on credit constraints Next steps Dynamic model with endogenous growth Open economy Households Eciency of allocation

16

Equilibrium Size of Financial Sector